The wood please, not the trees

When the inflation rate crossed the 6 per cent barrier on January 5, the government crossed a psychological threshold. The emphasis in policy began to shift from pushing up growth to containing inflation. This was apparent in P. Chidambaram recently conceding that monetary restraint may be needed. This, even after he pointed out that most of the current price rise was caused by shortages of agricultural and other primary products and, therefore, was not susceptible to control by monetary measures.

This shift of emphasis displays a regrettable inability to learn from our past mistakes. In January 1996, the rate of growth of industrial production had risen to an all-time high of 16.1 per cent and stayed there for three months. But by November, it collapsed to 3.5 per cent and stayed in that vicinity for the next six years. The cause was the Narasimha Rao government’s decision to control the industrial boom through monetary policy alone, instead of the old Keynesian way of reducing government expenditure.

We seem to be about to repeat that mistake. Industrial growth touched 14.4 per cent in November and manufacturing rose by 16.7 percent. On December 8, non-food bank credit had risen by 30.4 per cent, far more than the rise in deposits. The economy is, therefore, on the edge of overheating. But as in 1996, the government is once again relying solely on monetary policy to ‘cool’ it down. While the industrial recession that is likely to follow will not be as deep and long-lasting as the last one, it is hard to see how it can be avoided.

In 1996, too, the avowed aim of the government was to bring down inflation, which had exceeded 11 per cent by May. The Congress had just lost two assembly elections in the ‘safe’ states of Andhra and Karnataka, and an internal assessment in the party had mistakenly identified inflation as one of the two prime causes of the defeat. The party high command decided that with elections barely a year away, it simply had to bring inflation down. But instead of doing so by reducing government consumption expenditure, it opted for the easier way of tightening the money market.

Most economists now admit that the brakes were applied too suddenly and too harshly. Call money rates shot up to over 60 per cent and stayed there for weeks. But it seemed to have worked. By October, the inflation rate had come down. Only a very few of us warned that it may have pushed the economy into a recession. And that is what happened. By the end of the year, it had become apparent that we had killed not only inflation but also investment. Corporate sector investment fell by 23 per cent that year and by another 40 per cent in 1996-97. It then continued to fall till, in 2001, shareholders were not even picking up rights issues of new shares.

In October 2000, the growth of industrial production fell to zero. In real terms, tax revenues also virtually stopped growing. Since the government still made no effort to control the growth of its non-developmental expenditures, its relentless borrowing pushed up the real rate of interest ever higher till it touched 8 per cent in 2000 and 2001 even for blue chip companies. It was not till 2003 that a recovery set in.

This time too, the burden of moderating the boom is falling on monetary policy alone. The potential impact of buoyant tax revenues (36 per cent) on the revenue deficit has been partly nullified by the impact of stagnating non-tax revenues (3 per cent). As a result, the revenue deficit is only running 3 per cent below last year, nowhere near enough to make an impact on inflation.

But the effects of the tightening of the money market had become visible even before the latest sharp increase in the cash reserve ratio (CRR). In November, the year on year growth in the sale of consumer durables had fallen by 5 per cent. While other causes could have contributed to this decline, what is unmistakable is the impact of the rise in interest rates on the demand for new housing. As little as 18 months ago, mortgage rates were 7.5 per cent. In early December, even before RBI Governor YV Reddy announced the increase in the CRR, it had touched 11.5 per cent. In the coming weeks, the combined effect of the Rs 14,500 crore that the RBI has withdrawn from the money market, and the steam engine growth of demand for non-food credit, will push these over 12 per cent.

Mumbai is already experiencing a sharp decline in the demand for new housing. Delhi and other metropolis are bound to follow. But builders are already committed to projects which they cannot now stop. So we are in the early stages of a property bubble. Once the building cycle reverses itself, we could plunge into recession.

The only way to cool down the economy without tipping it over into recession is to cut the revenue deficit. The current boom, and buoyancy in tax revenues, has given the government a chance to bring the revenue deficit down to zero with a single set of expenditure reforms — a very mild version of shock therapy. That will free private savings for productive investment and ease the pressure on the money markets. It will also moderate inflation without discouraging investment. The approach paper to the 11th Plan has hinted at the desirability of doing this. It would be a tragedy if Manmohan Singh lets the opportunity slip.